TOKYO The Bank of Japan is increasingly confident that the economy is weathering a recent tax increase and is on its way out of deflation, but another threat to that optimistic scenario is lurking - weak exports.
If shipments abroad continue to fall short of the central bank's forecasts, the recovery in the world's third-biggest economy could stall and the BOJ might be forced to ease policy again in the coming months.
Growth has returned to Japan, helped greatly by massive monetary stimulus unleashed 13 months ago when Haruhiko Kuroda took the helm at the BOJ. Early signs support the bank's view that last month's increase in the national sales tax will not derail the recovery or drag Japan back into deflation.
But the BOJ has been notably wrong about exports. The weak yen was supposed to boost overseas shipments in time to take up the slack when consumption took a hit from the April 1 tax increase to 8 percent from 5 percent.
"The BOJ's main scenario is for exports to gradually pick up. But exports remain the biggest risk to the outlook," said an official familiar with the BOJ's thinking.
The central bank still forecasts export growth will accelerate and Kuroda's assurances that prices are on track to hit his 2 percent inflation target have prompted investors to scale back expectations of further easing later this year.
But Kuroda is always careful to say the BOJ will not hesitate to ease again if its price goal is threatened.
Some analysts say that if exports remain feeble, the BOJ may be forced as soon as July to expand its stimulus by ramping up its purchases of government bonds and other assets.
In a further sign that slow shipments are weighing on the recovery, Japan on Monday posted a much lower-than-expected current account surplus for March, capping the smallest fiscal-year surplus on record.
There are growing signs that policymakers are becoming less confident about an export upturn.
The central bank's half-yearly outlook cited exports as a key threat to economic recovery, saying they may not increase strongly even as overseas demand picks up.
Kuroda, for all his optimism, also keeps bringing up exports as a significant risk factor.
Big manufacturers, too, are cautious. Toyota Motor Corp warned on Thursday its profits may fall this business year as the export tailwind that it and other Japanese carmakers have received from the yen's 18-month slide fades.
CLINGING TO HOPE
That creates a communication headache for the BOJ.
Preserving confidence in a sustained economic recovery is an essential part of Kuroda's strategy. Voicing doubts about a key element of that scenario too openly could hurt that confidence.
"That's why the BOJ needs to cling to its projection that exports will recover," said a former BOJ official with knowledge of the central bank's thinking.
"The export recovery hasn't happened as quickly as the BOJ wanted. I'm not sure whether everyone at the bank is confident this will happen."
BOJ policymakers stress that export weakness alone will not trigger further easing. But they acknowledge that more stimulus may be forthcoming if the economy is hit by a double-whammy of persistent export softness and failure of household consumption to rebound from the post-tax hike slump.
Some of them say July is key because they will have a better sense by then if exports are picking up as the BOJ expects, and whether consumer spending has weathered the sales tax hike.
"The BOJ will probably use weak exports as an excuse to revise down its rosy economic projections later this year," said Masaaki Kanno, a former BOJ official who is now chief Japan economist at JPMorgan Securities.
"It's easy to blame exports because they are swayed by external factors beyond the BOJ's control," said Kanno, who expects the central bank to ease again in July.
Annual export growth peaked at 18.6 percent in October and skidded to 1.8 percent in March, the latest data available and the weakest in a year. Shipments to the rest of Asia, half of the total, were up just 1.4 percent for the month.
Moreover, export volume fell 2.5 percent in March, showing that the yen's slide - driven by the BOJ's easy-money policy - is not giving Japanese goods the competitive edge it once would have.
After having pushed back the expected timing of an export pickup by several months in its assessments, the central bank now expects a rebound by the middle of this year.
The BOJ is also starting to cite "structural factors" for the disappointing performance -- Japanese manufacturers continuing to shift production overseas and some, such as electronics exporters, possibly losing their competitive edge to rivals in South Korea, Taiwan and elsewhere.
"Japan won't return to the days when the weak yen had a more direct impact on exports," said one official.
But as these trends are not exactly new, bringing them up only underscores the BOJ's lack of conviction that exports will recover, some analysts say.
Like the BOJ, many private-sector analysts predict a gradual pickup in exports, but some warn that such modest gains may not be enough to make up for the post-tax hike slump in domestic demand.
Household spending and housing starts are set to slow compared with last year and the impact of last year's fiscal stimulus will also start to fade.
Economists expect the economy to grow 0.7 percent in the fiscal year that began last month, well below the BOJ's 1.1 percent forecast, according to a survey by the private Japan Center for Economic Research.
Even that conservative estimate assumes export growth will have to accelerate to 5 percent this fiscal year from 3.5 percent in the previous year.
Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute, warned that exports must pick up this quarter and grow enough to offset the post-tax hike weakness in domestic demand for the BOJ's rosy scenario to hold.
"Otherwise, a recession is not out of the question and the BOJ may need to act again," he said. "The verdict should be out around July."
(Editing by William Mallard and Tomasz Janowski)